The IS- LM Curve

8/2/2019 The IS- LM Curve

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The IS- LM Model


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Goods market equilibrium IS curve

Goods market equilibrium :

Y = C+I (AD) or

Investment=Savings at different rates ofinterests or

Planned spending= Planned output

Therefore, it is called I equal S (Investmentequal Savings)or I-S function.


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For the derivation of IS curve, rate of interest

is an important determinant of investment

making the latter an endogenous variable. There exists an inverse relationship between

the interest rate and investment. When firms

borrow to purchase investment goods, they

have to pay an interest rate. When interest

rate increases, the cost of borrowings

increases. This decreases the profitability of

the firms and thus,planned investment

decreases.


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Increase in investment demand(I) increases

aggregate demand(AD) and thus raises the

equilibrium level of income. In the derivation of the IS curve, we seek to

find out the equilibrium level of Y as

determined by the equilibrium in goodsmarket by a level of investment determined by

a given rate of interest.

IS curve relates the equilibrium levels ofnational income with rates of interest.

(explained in the following graphs)


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In fig (a), the fall in interest rate increases the investment level

and shifts the AD curve upwards resulting in equilibrium at a

higher level of national income.(fig.b)


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Thus IS curve is a locus of

those combinations of

rate of interest and the

level of national incomeat which good market is

in equilibrium. (fig.c)


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Slope of IS curve :

Decline in interest rates causes increase in

investment expenditureThis causes an increase in the aggregate demand

moving the AD curve upwards.

This leads to an increase in the equilibrium levelof national income.

Thus a lower rate of interest is associated with a

higher level of national income and vice versa.This makes the IS curve slope downwards.


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Steepness of IS curve

Depends upon

1. Elasticity of the investment demand curve i.e.

responsiveness of investment to the rate of

interest.

2. The size of the multiplier.- Multiplier depends

on mpc. Higher mpc means steeper AD curve

(c=a+by). It also means highier multiplier i.e.

greater increase in equilibrium level of

national income and a steeper IS curve.


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Shift in IS curve

The level of autonomous expenditure

determines the position of the IS curve and

changes in autonomous expenditure cause

shift in it.

Autonomous expenditure means the

expenditure be it investment expenditure,

government expenditure or consumption exp.Which does not depend on level of income or

rate of interest.


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Graphical explanation

Rateofint

We illustrate the shift in the IS curve by making changes in government exp (G)


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Since the increase in the

income to OY2 has not

been brought about bythe changes in the

interest rate but

autonomous of it, I doesnot imply movement

along the previous IS

curve but will cause an

upward shift in it (IS)


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Money Market Equilibrium- The

LM Curve

As per keynes, demand for money to hold

depends upon transactions motive and

speculative motive.

Money held for transactions motive is a

function of income.

Greater the level of income, greater the

money held for transaction motive and

therefore higher the level of money demand

curve.


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Graph- LM curve


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Slope of LM curveDepends on two factors : 1) The responsiveness

of demand for money(liquidity preference) to

the changes in income.

With the increase in income, demand curve for

money moves up disturbing the equilibrium .

For the equilibrium to be restored, rate on

interest moves up.

Hence the speculative demand for money goes

down. Given the speculative demand, higher

the rise in the rate on interest, steeper the LM

curve.


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2)Responsiveness of demand for money to the

changes in the rate of interest :Lower the elasticity of liquidity preference with

respect to the changes in interest rate, the

steeper will be the LM curve and vice versa.


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Shift in the LM curve due to

change in money supply

Rateofint


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Shift in LM curve due to change in

money demand function

The other factor causing shift of the LM curve

is the change in liquidity preference function

at a given level of income.

This will lead to the rise in the rate of interest

and a shift in the LM curve to the left.

If, with the given situations, the rate of

interest has to be maintained, the income

should be reduced and the money demand

function must shift back to its original level.


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Intersection of IS- LM curves


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At the point of intersection of the IS and Lm

curves, the rate of interest and the income are

related in such a way that :

1) The goods market is in equilibrium i.e Agg

demand= aggregate output.

2) The money market is also in equilibrium i.e.

demand for money is in equilibrium with the

supply of money.


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The IS- Lm curve analysis has succeeded in

synthesizing the monetary and fiscal policies. With the IS-LM curve analysis, we are better

able to explain the effect of changes in certain

important economic variables such as desireto save, the supply of money, investment,

demand for money on the rate of interest and

level of income.


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Effect of changes in the supply of money on

the rate of interest and income level:

When supply of money increases, rate of

interest falls and Y increases.

When supply of money decreases, the rate of

interest increases and Y decreases.


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Changes in the desire to Save or propensity toconsume:

The increase in mpc moves the AD curve up

increasing the national income. This movesthe IS curve to the right and moves up the rate

of interest at the equilibrium level.


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Changes in autonomous investment and

government expenditure:Increases the investment expenditure increasing

the agrregate demand. IS curve moves to the

right and increases the rate of interest andnational income.

.


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Changes in demand for money or liquidity

preference:

Affects the LM curve. Increase in money

demand moves the LM curve to the left. Thus

the equilibrium rate of interest will rise andnational income will fall.

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The IS- LM Curve